A textbook, when explaining the effects of higher interest rates, claims that:

The initial equilibrium is with real output at $Y_0$,the price level at $P_0$ and the rate of interest $r_0$. An increase in the rate of interest to $r_1$ will need to be balanced by a decrease in money supply to maintain money-market equilibrium.

The illustration below accompanies the claim.

enter image description here

How/why does the money supply shift leftwards to accommodate a return to "money-market equilibrium", and what is such an equilibrium to begin with?

Additionally, is this shift automatic or is it one where the government must intervene?

  • $\begingroup$ It is hard to think of a change in interest rates without a corresponding change in the money supply. Supposing the Federal Reserve enacts contractionary policy, we necessarily see the money supply fall and rates rise. Generally, you should think of one as the impetus for the other and not one as some thing that must happen to return a system to equilibrium. $\endgroup$
    – 123
    Jan 31 '17 at 15:44

The graph is a little misleading.

Imagine the interest rates increase without $MS$ shifting to $MS1$. Here the demand for money is less than the supply, so there is a surplus. If the MS does not shift, eventually the interest rate will fall again until the shortage is no longer (we are back in equilibrium). If the Fed wants to maintain the higher interest rate, $r_1$, it also must shift $MS$ to $MS1$.

  • $\begingroup$ I think you meant "Here the demand for money is less than the supply, so there is a shortage....". Besides that, yours is a good explanation. $\endgroup$
    – user98937
    Feb 2 '17 at 9:26
  • $\begingroup$ When Q_d < Q_s, that is a surplus. I believe I am correct. $\endgroup$ Feb 2 '17 at 17:40

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.